Accountability Arrangements for Financial Sector Regulators

Abstract

Why are policymakers reluctant to grant independence to the agencies that regulate and supervise the financial sector, despite mounting empirical evidence that independence makes for a healthier financial system?

Why are policymakers reluctant to grant independence to the agencies that regulate and supervise the financial sector, despite mounting empirical evidence that independence makes for a healthier financial system?

First, if not structured properly, independent regulatory and supervisory agencies (RSAs) could become an unelected fourth branch of government that is not subject to the same checks and balances as the executive, legislative, and judicial branches. Because supervisory actions often involve issues that are highly political—such as a decision to save or to close a bank—and can also affect individual property rights, making them independent might seem to be too great a delegation of authority.

Second, many policymakers are concerned about the possibility of “regulatory capture”—that, without proper political oversight and control, regulators will promote industry interests over those of the public.

Third, self-interest may play a role in policymakers’ reluctance to relinquish their oversight over the financial sector. In many parts of the world, the political class still sees the financial system as a vehicle for generating rents, campaign contributions, or bribes and for implementing redistributive policies (directed and connected lending) that can make them popular with voters. Politicians may thus try to remain formally or informally involved in financial sector regulation and supervision instead of delegating these responsibilities to an independent agency.

To the extent that the reluctance to grant independence to RSAs lies in a genuine concern about ensuring that the agencies remain subject to constitutional checks and balances, the solution is to make financial regulators fully accountable for their actions. However, adopting accountability arrangements has been difficult in practice, because accountability is an elusive, multifaceted, and complex concept, and—even more important—because accountability is often seen as synonymous with control, and thus as incompatible with independence. Indeed, many mistakenly believe that there is a trade-off between independence and accountability, whereas, in reality, well-structured accountability arrangements for RSAs are fully consistent with, and supportive of, independence and good governance.

The relationship between accountability and independence

The uneasiness with granting independence to RSAs is based on confusion about accountability and its relationship to independence. Independence is a straightforward concept that is relatively easy to define. In statutes and laws, an agency’s independence usually means that it does not accept directives from the government. Accountability is a more elusive and less easily defined concept. This elusiveness has obstructed efforts to include concrete and workable accountability arrangements in the legal framework governing financial regulators.

Coming to grips with accountability and its relationship with independence requires the clarification of a few principles:

  • Agency independence is never absolute. The executive branch—which, in a democracy, is accountable to voters—delegates power to the agency. The agency therefore needs to give an account of its activities and, if necessary, to take action to redress its shortcomings.

  • Accountability is not synonymous with control. It entails a network of complementary and overlapping oversight mechanisms and control instruments under which no one actually controls the independent agency, yet the agency remains “under control.”

  • Accountability and independence are complementary. Accountability reinforces an agency’s independence by giving its actions legitimacy. The agency builds its reputation by explaining to the public how it is pursuing its mandate and allowing the public to express their views about its policies. A regulatory agency with a good reputation is more likely to be trusted by the public and given the benefit of the doubt in controversial cases. And a good reputation also bolsters the agency’s independence.

Differences between regulators and central banks

In designing accountability arrangements for financial regulators and supervisors, it might be tempting to use those designed for central banks as models, given that central bank independence is far more advanced than RSA independence and that central banking and financial (especially bank) regulation are closely related. However, it is not possible to use the accountability mechanisms set up for monetary authorities for financial supervisors, because RSAs have broader and more complex mandates and powers than central banks (see Table 1, page 4).

Table 1.

Accountability arrangements for central banks and regulatory and supervisory agencies need to reflect the differences between them

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What are the main differences between RSAs and monetary authorities that have implications for accountability?

  • It is typically more difficult to measure an RSA’s performance against its mandate than it is to measure the performance of monetary authorities. A well-defined statutory objective against which the agency’s performance can be measured is generally considered a key requirement for holding independent agencies accountable. For central banks this is, increasingly, price stability, and central bank performance can be readily measured against this stated objective. For RSAs, the issues are more complicated on three counts: the RSAs’ goals may not be explicitly or clearly articulated in the law; RSAs often face multiple objectives—for example, ensuring the soundness of the banking system, reducing financial crime, protecting consumers, and preventing market abuse and money laundering; and these objectives are typically hard to measure.

  • The tension between transparency and confidentiality is greater for RSAs than for central banks conducting monetary policy. Whereas the reasons for monetary policy decisions cease to have any commercial sensitivity or importance after a relatively short time—and can thus be published relatively quickly—the same is not true of regulatory decisions. In the course of an enforcement procedure, RSAs must protect the interests of all stakeholders and ensure the fairness and impartiality of the process. Publicity could undermine the conduct of investigations and prevent impartial decision making. Supervision also inevitably deals with matters of acute commercial sensitivity. For example, the disclosure—even years later—that a bank has been required to take corrective action may be destabilizing and undermine confidence in the banking sector. Nonetheless, the presumption should be that RSA decisions and the reasoning behind them are a matter of public record, even if this disclosure occurs well after the event. By encouraging transparency, supervisory agency decisions are more likely to be well reasoned and grounded in both law and fact. Publicity reduces the scope for arbitrary decisions.

  • Unlike the monetary authorities, RSAs generally have broad regulatory (rule-making) powers. These include prudential rules, reporting and disclosure requirements, and organizational prescriptions and rules of conduct.

  • Financial regulators have broad supervisory and enforcement powers that require them to be accountable both to the industry they regulate and to the country’s judiciary. The RSAs’ enforcement and sanctioning powers set them apart not only from central banks but also from the court system. First, there is no counterpart to RSA enforcement powers in the powers granted to a central bank with respect to its monetary policy role. Second, there are important differences between the way an RSA uses its enforcement powers and the exercise of similar powers by the court system. Unlike judicial enforcement, regulatory enforcement is proactive: RSAs take enforcement action on their own initiative and in accordance with their mandate as defined in their statutory objectives. Enforcement is not the RSAs’ mandate but the means by which RSAs fulfill their mandate—the achievement of their statutory objectives. An RSA’s use of its enforcement powers needs to be publicly justified. The RSA has to demonstrate that its enforcement policy strikes the right balance between cooperative compliance-oriented enforcement action and deterrence-oriented coercive action. The performance of RSAs, unlike that of the courts, cannot be measured by the number of cases they try or convictions they obtain, but, rather, by overall compliance and the achievement of their statutory objectives.

  • RSAs operate in a “multiple-principals” environment. In view of the range of interests potentially affected, the traditional, vertical, “single principal-single agent” model applicable to central banks—whose main responsibility is to the executive or the legislative branch—is not relevant for RSAs. RSAs operate in an environment in which the appropriate accountability mechanisms are diversified. Although the legislative, executive, and judicial branches are, for obvious reasons, the most important principals of RSAs, RSAs must also be directly accountable to a broader range of principals—including the entities they supervise, the customers of those entities, the public at large, and peers.

Designing accountability arrangements

A complex and specialized activity like the regulation and supervision of financial markets calls for multiple accountability mechanisms. Accountability arrangements fall into different categories. An effective set should contain a balanced mix of these categories.

  • Ex ante accountability refers to reporting before an agency acts (for example, through consultations with stakeholders on supervisory and regulatory policies).

  • Ex post accountability refers to reporting after actions have been taken (for example, in annual reports).

  • Explanatory accountability requires giving the reasons for and explaining the actions taken.

  • Amendatory accountability is the obligation to redress grievances by remedying defects in policy or rule making.

  • Procedural accountability refers to requirements related to the processes that must be followed.

  • Substantive, or functional, accountability requires that the regulatory and supervisory actions taken be justified by the agency’s objectives.

  • Personal accountability refers to the discharge of responsibilities delegated to individuals in the agency.

  • Financial accountability refers to the presentation of financial statements.

  • Performance accountability refers to the extent to which the agency meets its objectives.

Before setting up accountability arrangements, policymakers need to do the following:

  • Ensure that the agency’s mandate and objectives, as set out in the law, are clear and specific.

  • Supplement the mandate with a set of operating principles and procedures or specify the result the agency is expected to achieve.

  • Spell out clearly in the law the accountability arrangements with respect to the three branches of government and all other stakeholders.

The nature of RSAs’ accountability to the various principals is described below, along with some “do’s” and “don’ts,” and summarized in Table 2 (page 8).

Table 2.

Mapping possible accountability arrangements for regulatory and supervisory agencies

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Accountability to the legislature

Parliaments exert their influence on supervisory activities by dint of their legislative powers—that is, they are responsible for establishing the legal frameworks under which RSAs operate. The accountability of RSAs to the legislature has three purposes: ensuring that the RSAs’ mandate is appropriate, determining whether the powers delegated to financial regulators are exercised effectively and are suitable for achieving the intended objectives, and providing a channel of communication in the event it becomes necessary to amend the legislation. Legislative bodies should not exercise immediate power over RSAs or provide concrete guidance as to how RSAs should carry out their supervisory activities.

  • Do spell out in law RSA reporting requirements to parliament, including format and frequency.

  • Do have RSAs report to parliamentary committees rather than to the full parliament. Committees generally have greater relevant expertise and more scope for independent action.

  • Do allow parliament to make ad hoc inquiries.

  • Don’t allow the legislative branch to cede its oversight role to the executive branch.

  • Don’t allow parliamentary representatives to sit on boards or committees that have operational or policy functions. Although it may be useful to have a parliamentary representative on the board of an RSA, the danger is that the representative will cross the line between accountability and control if s/he has a seat on decision-making bodies that also deal with confidential information.

Accountability to the executive

A direct line of accountability to the executive branch (typically the finance ministry) is needed because the executive bears the ultimate responsibility for the direction and development of financial policies, is typically the issuer of regulations, and has a key role in appointing the chief executive and/or board members of the RSA.

  • Do spell out the RSA’s reporting requirements, format, and frequency in the law, to ensure that it keeps the government informed of financial sector developments. Frequent reporting and formal or informal contacts are the best ways to establish and maintain contact.

  • Do allow for ad hoc inquiries by the executive branch about how the RSA is implementing the financial regulations.

  • Do ensure that the criteria for dismissing RSA senior officials are specified in the law.

  • Don’t allow the finance ministry, in countries where it has oversight authority, to become directly involved in operational and policy decisions. Oversight itself promotes accountability, but it must not be allowed to become a means of exerting political influence on the RSA. The finance ministry should itself be accountable to the legislature for its handling of the relationship with the financial supervisor.

Accountability to the judiciary

Individuals and companies affected by an agency’s decisions should have the right to seek legal redress in the courts. Given the extensive legal powers conferred on RSAs, judicial review of supervisory measures is a cornerstone of RSAs’ accountability. This form of accountability, which is exercised after the fact, is meant to ensure that RSAs act within the limits of the law.

  • Do ensure that there is scope for administrative review of the RSA by the judiciary. This is important for assessing the RSA’s observance of due process when it makes decisions affecting individuals or companies, such as issuing or withdrawing licenses and imposing sanctions.

  • Do ensure, if some form of judicial review is deemed necessary, that the procedures are clearly defined so that the review process cannot hold the supervisory process hostage.

  • Do include procedures to hold the RSA liable for losses caused by its failure to exercise its supervisory powers in an appropriate manner.

  • Don’t place the administrative review in the hands of the oversight ministry because this may impair independence.

Accountability to other stakeholders

Most RSAs are financed in full or in part by fees levied on the institutions they supervise and are therefore, at least to some extent, accountable to those institutions. To the degree that consumer protection falls within an RSA’s mandate, it is accountable to consumers as well, whose complaints it must address. RSAs are also accountable to the public at large—the electorate, the ultimate source of democratic accountability.

Transparency, consultation, participation, and representation are powerful vehicles for establishing and maintaining accountability. Transparency can be achieved through the publication of all regulations, supervisory practices, and important decisions; annual reporting requirements; and regular press conferences and information events. RSAs should consult frequently with supervised institutions on policy issues. They should have arrangements in place for consulting representatives of parties likely to be affected by agency actions as to the appropriateness and practicality of proposed rules. Draft rules should be published for comment. Accountability to the industry and consumers can also be achieved by giving them appropriate representation on oversight boards.

  • Do establish arrangements making an RSA accountable to the entities that finance it.

  • Do promote transparency by requiring that the RSA disclose relevant information to all stakeholders.

  • Do ensure that the RSA consults with the entities it supervises in setting and modifying rules.

  • Do include representatives of the supervised industry and consumers on RSA oversight and advisory boards.

Accountability on financial matters

To ensure its autonomy, it is desirable that an RSA be financially independent of the government. One way to achieve this is for its supervisory activities to be financed by the entities it regulates. However, this may open the door to undue influence from the supervised entities. Therefore, regardless of how it is financed, an RSA should be required to report transparently on how it spends its funds.

  • Do allow for independent financial audits of the RSA to ensure proper financial management, the accuracy of financial reports, and the efficient use of resources.

  • Do establish an internal inspectorate—with direct access to all RSA records and information—that reports regularly to the oversight board and/or legislature.

External monitoring

International financial integration has intensified calls for the standards applied by RSAs to be subjected to monitoring outside their own national jurisdictions in the hope that such a move will limit cross-border contagion of local financial sector problems. Two mechanisms have recently been developed to provide external monitoring of domestic regulatory and supervisory frameworks—surveillance by the IMF and the World Bank under the institutions’ Financial Sector Assessment Program (FSAP), and mutual evaluations and “peer” reviews.

Under the FSAP, external experts assess the standards applied by regulatory agencies in countries worldwide, the objective being to evaluate the quality of regulatory and supervisory frameworks. Other international organizations and groupings, such as the Financial Action Task Force (FATF) and its regional bodies, conduct mutual evaluations and peer review in defined areas, such as anti-money-laundering legislation, in an effort to ensure the consistent implementation of international standards. Countries may also monitor each other to gauge the degree of equivalence between their regulatory and supervisory frameworks. Although surveillance, mutual evaluations, and peer reviews are not accountability arrangements in the strictest sense, they do require RSAs to give an account of their standards and practices to external experts, to the international community, and to the public at large, thereby adding to the RSAs’ legitimacy.

Broadening the debate

Progress toward RSA independence has been hampered by the fear that independence could constitute too great a delegation of authority, given the broad powers assigned to these agencies. But a demystification and clarification of the concept of accountability for financial regulators—along with well-designed arrangements to keep the complex mission and work of RSAs “in check”—can address this fear. Indeed, if well implemented, good accountability arrangements will lead to a win-win situation in which politicians are satisfied that RSAs are in check and RSAs are satisfied with arrangements that guarantee their independence. Some of the accountability arrangements currently in place in selected countries are shown in Table 3 (pages 14–21).

Table 3.

Formal accountability arrangements for financial supervisors in selected countries

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Source: National laws.

Other ways to facilitate accountability not discussed in this Economic Issue include making the mandate of an RSA as concrete as possible, thereby providing the agency with a clear definition of the functions to be exercised in pursuit of its mandate, or undertaking some institutional reform to ensure that agencies do not possess duplicative or overlapping mandates.

This Economic Issue focuses on financial sector regulators, but its suggestions on designing accountability arrangements for RSAs have a broader application. First, interest in independent RSAs for other economic sectors is increasing worldwide. Second, a growing number of central banks are adding the achievement and maintenance of financial stability to their official mandate (in addition to monetary or price stability). The financial stability mandate is as hard to define as the mandate of RSAs. A recent study demonstrated that the accountability arrangements currently included in central bank legislation in most member countries of the Organization for Economic Cooperation and Development in response to the financial stability mandate are poorly designed and fall short of providing the necessary assurances that the independent central bank has met its financial stability objectives. Third, the debate about the accountability arrangements of the European Central Bank (a regional institution without a truly regional government) remains unresolved. In addition, there is an emerging debate about the proper financial supervisory structure for the euro area, which entails its own accountability discussion. We hope that this Economic Issue can contribute to these and other debates.